The US interest rate rise a long time coming

Transcription

1 GLOBAL EQUITIES FOR PROFESSIONAL CLIENTS ONLY DECEMBER 2015 The US interest rate rise a long time coming Chris Connor Portfolio Manager, Global Equities After a lengthy period of speculation as to when it would happen, the US Federal Open Market Committee (FOMC) finally announced the much-anticipated rise in its interest rate, up by 25 basis points. This is the first increase since the rate was cut to near zero during the 2008 global financial crisis. On the news, markets reacted well, trading higher after the announcement. However, while much of the focus has been on when this rise would be implemented, arguably the more important questions are why rates are normalising now, the expected growth trajectory and how the hike is likely to impact investor focus and company performance. The right conditions? The US Federal Reserve (Fed) has waited until there has been more decisive evidence of the strength of the economic recovery in the US to implement the increase. Balance sheet-driven recessions (as witnessed in the US since the financial crisis) are typically much more destructive than business-cycle recessions hence, the reason why the shift to monetary tightening has been so protracted, with the Fed unwilling to kill off any nascent recovery too soon. The Fed, though, now believes the US economy may have finally turned the corner. But while the Fed has judged that its key metrics are now pointing in the right direction, other data points are looking somewhat gloomier, most notably recent PMI numbers which have dropped below 50 and generally indicates the industrial economy is in contraction. Only time will tell if the policy decision is right, but perhaps what is of greater significance is the direction of travel from here onwards, and what this signals for the underlying economy. Positive signs of this recovery have included the following: $ Unemployment is now 5.0% (November 2015); in November 2008 it was 6.8% (peaking in October 2009 at 10%). 1 Quarter three 2015 GDP per capita is US$56,136, in quarter one 2009, it was US$46, Vehicle sales on a seasonally adjusted annual rate (SAAR) are 18.5 million (November 2015), from a low of 9.4 million in April However, on the negative, or more questionable side: $ The Purchasing Managers Index (PMI) is The 50 level is seen as the threshold between contraction and expansion. 4 The inflation rate is 0.5% (2% not including energy and food) year on year, November Labour force participation is now 62.5% (November 2015), while it was 65.9% in November Sources: 1 Unemployment data: US. Bureau of Labor Statistics, Civilian Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis UNRATE/, 4 December, GDP data: US. Bureau of Economic Analysis, Gross domestic product per capita [A939RC0Q052SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis A939RC0Q052SBEA/, 24 November, Vehicle sales: US. Bureau of Economic Analysis, Total Vehicle Sales [TOTALSA], retrieved from FRED, Federal Reserve Bank of St. Louis stlouisfed.org/fred2/series/totalsa/, 3 December, ISM Manufacturing Purchasing Managers Index: Institute for Supply Management retrieved from FRED, Federal Reserve Bank of St. Louis research.stlouisfed.org/fred2/series/napm, 1 December, Labour force participation: US. Bureau of Labor Statistics, Civilian Labor Force Participation Rate [CIVPART], retrieved from FRED, Federal Reserve Bank of St. Louis fred2/series/civpart/, 4 December,

2 active UPDATE: GLOBAL EQUITIES The trajectory of the rise Fed chair Janet Yellen has previously confirmed a controlled approach to the trajectory of rate rises, with gradual a key watchword in the Fed s vocabulary in the months leading up to the rise. This seems logical, as the US economy may struggle to adjust to a series of rapid rises and a strengthening of the dollar. Certainly, a slow and progressive path towards normalisation is likely to be preferable to most investors, allowing asset markets to absorb the changes steadily. What will it mean for companies? Our bottom-up stockpicking approach to investing means that while we assess macro-level events, ultimately we are focused on individual companies and how they are placed for the long term. When it comes to the impact on companies, the reason why rates have moved is more important than when. For most businesses, the economic improvement that justifies the rate rise is what s likely to drive their share price, not a move in policy rates in any explicit way. However, there are some specific areas that may be impacted more directly. Banks are perhaps the most obvious example of the companies that are likely to benefit from rising interest rates (see the separate in-depth analysis of the impact on banks). Higher rates mean they can charge more for lending. Insurers can also benefit, earning higher returns on premiums. Having said that, the probability that rates would go up has been well known in the market for some time. This is largely priced in and bank valuations look stretched. There is more fear of a negative impact on companies with higher levels of debt, or high-growth companies that trade on elevated earnings multiples in the short term. We re already seeing signs of distress in high-yield markets. We do not see a great risk to high-quality companies that use debt as part of their business model (such as regulated utilities and telecoms companies). Firstly, a small move in the policy rate doesn t necessarily have any impact on longerterm financing costs. Even if we assume a parallel shift in the yield curve and a constant spread of corporate-debt costs over government yields, only a small proportion of debt will require refinancing every year giving companies plenty of time to adjust their capital structures appropriately. What will it mean for markets? What is likely to have a larger short-term impact is the market s perception of these high-quality companies as bond proxies. There may well be fear that rising risk-free yields will encourage a shift away from higher-dividend paying equities. Again, given the small policy rate moves we re talking about, we think this impact is likely to be fleeting. The quality and stability of these business models will remain attractive to investors through cycles. A rising interest rate environment, or a shift in investor sentiment, could raise the implied rate of return demanded by investors. This can be particularly difficult for companies with significant growth in the future, as outer-year earnings are discounted back at a more punitive rate. In this scenario, valuations could fall even though there is little change in a company s fundamentals. In addition, if the economic backdrop were to improve, investors may be more tempted by lower-quality, cyclically-exposed names that have more potential When it comes to the impact on companies, the reason why rates have moved is more important than when. For most businesses, the economic improvement that justifies the rate rise is what s likely to drive their share price, not a move in policy rates in any explicit way. for an improvement in earnings in the short term. This could lead to profit taking in higher-growth companies (such as those found in the technology or healthcare sectors). For US companies, if rate rises help strengthen the dollar, it will be good for importers and bad for exporters. Emerging market countries with lots of US dollar debt would likely suffer in this scenario. The bottom line? A 25 basis point (bps) change in a policy rate is unlikely to have any meaningful direct impact on company fundamentals. What is likely to be more important is the signaling impact will this move be seen as the first of many, and what will this mean for consumer, corporate and investor behaviour? We re at a difficult crossroads signs of an improving economy are very welcome, but anything that spooks an expensive equity market could lead to painful share price moves in the short to medium term.

3 The impact on banks not all good news Virginia Martin Heriz Global Financials Analyst So the Fed has just hiked interest rates by 25bps. What does this mean for the banks? Are they going to make money out of it or are we heading for more of the same? This question is far more complex than it initially appears, and the answer depends on two broad factors: first, what that rate rise really means, and second, the structure of a bank s balance sheet. The real meaning of the rate rise Let s unpick the first factor: if this rate hike is the result of an accelerating economy, and it is the first in a series of incremental increases, banks have good reason to be optimistic. If, on the other hand, the rise is not seen as a part of a sequence of long-term hikes, it is likely to have only a muted impact. The competitive landscape An isolated increase of 25bps is not actually that materially significant for improving bank margins. This is because what has been damaging net interest margins has been the aggressively competitive landscape on bank lending, especially commercial lending. With loan-to-deposit ratios below 100%, many US banks don t really know what to do with their liquidity. With dividend distributions effectively capped at 30% by the Fed and buybacks having to be rubber-stamped every year, banks have found themselves with excess capital in their balance sheets which they can t return. Rather than letting that excess liquidity and capital languish in the dark recesses of their balance sheets, they are happy to put it to work. On the other side of the fence, corporates are swimming in cash. And this is a poisonous combination: excess capital and muted demand means the banks will fight for every scrap of new lending. When interest rates are high and competition is fierce on the asset side, banks could let off some steam by paying less to their depositors. But with rates close to absolute zero, that is not an option. A 25bps lift in interest rates removes some of that pressure, but in order for margins to take off, what is really needed is for competition on the asset side to abate. Signs of recovery? And how does competition relax? A higher level of rates can help as that gives banks the opportunity to make money on the lending and on the deposit side. But more helpful would be an increase in loan demand from corporates and consumers, which we will see as the recovery gains momentum. If this 25bps rate rise is the prelude to an accelerating economy and an increase in loan demand, this is good for bank margins. Also, if that is the real reason behind this rate rise, this initial hike will not be an isolated event and we can look forward to further increases. There is a caveat here though: the Fed will have to navigate the treacherous waters of a strong US dollar (US$); in a world where everyone is easing, a tightening Fed policy may result in a stronger US$, which may in turn impact exports and derail the whole recovery. Balance-sheet structure The second factor is the structure of bank balance sheets. Many banks tend to hedge their interest rate sensitivity. With rates low for so long, the banks that have positioned their balance sheets to be sensitive to rising rates will benefit from the rise. How? First, if they keep part of their assets floating, this loan book will reprice continuously as interest rates rise. And second, by locking in long-term funding at bargain rates, this cost will not increase until these set rates expire. Is the rate rise priced in? US bank price/earnings (FY2 p/e) ratios are close to their post-crisis peak levels. In other words, valuations are not cheap. Shareprice performance from here is more likely to come from earnings growth rather than a multiple re-rating. Consensus expects mid-high single digit revenue growth at US banks into Bearing in mind the outlook for loan growth is modest, there does not seem to be meaningful margin compression baked into analysts forecasts. If this 25bps hike is a one-off, competition will come back with a vengeance, margins will erode and analysts will have to rethink their numbers. It is hard to see banks outperforming in such a scenario. Only if this is the first of many rate hikes (in quick succession) can we make a case for competition abating for good, healthy loan growth and revenue upgrades that will translate into sustained outperformance.

4 Emerging markets: meeting the rate hike head on Kim Catechis Head of Global Emerging Markets In emerging markets, there is a mixed response to the US Federal Reserve (Fed) rate hike. On the one hand it is viewed positively: an indicator of renewed confidence in the US economy, which is important for many emerging market companies prospects; and after seven years, finally some signs of a return to normality. It is also a reason to believe that money will once again obey the natural laws of finance; in other words, investors becoming more discriminating and favouring higher-quality businesses. Inevitably though, adjustments following large-scale changes in monetary policy are rarely smooth. The key concern of investors is not the immediate rate hike that was widely expected rather the next one. Will the Fed tighten again in March, or perhaps in June? If it does, the balance of responses will probably shift toward the negative. The first segment of the market where the negative effects of the rate rise will be felt is in the cost of financing debt in US dollars. The subsequent increase in financial costs is certainly likely to pose short-term challenges to some emerging market companies. However, it is worth noting that, while the level of emerging market debt has increased significantly in the last decade, only a small part of it is estimated to be denominated in US dollars. Indeed, evidence of a decreased appetite for US dollar debt is also presented by the significant slowdown in lending to the emerging market asset class by developed market banks. This changed debt profile of emerging market companies means that they are less vulnerable than in the past. The strengthening US dollar will of course also impact commodities, for which an already complex outlook just got tougher. Furthermore, it could prompt investors to withdraw more of their assets from emerging markets, including their equity investments. Indeed, most of these markets have already seen significant outflows, as investors positioned themselves for the widely expected rate hike. In 2015, emerging markets registered record net outflows 1, reaching higher levels than those seen in the financial crisis in Looking past short-term pain For several years the prospect of higher US rates has been a focus of concern for emerging market investors. Although short-term volatility is highly likely, we expect positive outcomes in the long term. Prior to the hike, US policymakers took great pains to stress that employment and inflation data had to be within acceptable parameters. The rate hike points to buoyancy in the US economy, which has positive implications for demand in many markets. Mexico is a case in point. The Mexican central bank has committed to move in line with the Fed as the country s business cycle has essentially synchronised with the US, with a multitude of Mexican businesses dependent on sales in the US. Needless to say, these are more likely to thrive in a growth environment. However, this commitment will wane if the Fed follows up with a second rate hike in short succession, as Mexican inflation is at record lows and GDP growth is currently below expectations. Across the rest of the asset class, currency moves accentuate divergent policies by central banks and further constrain the room for governments to manoeuvre. The main risks remain the absence of external economic stimuli and the corporate sector struggling to generate top-line growth and improve profit margins. In Asia and Brazil particularly, this task is made harder due to the increase in corporate indebtedness. Growth forecasts continue to move down, and there remains a risk of disappointment in fourth-quarter reporting. The US rate hike is just one of many factors driving emerging market assets. Some indicators, such as composite manufacturing Purchasing Manager Indices (PMIs) and industrial production, suggest that emerging market economies are now approaching a bottom. As well as progress with regards to structural/institutional reforms, banking systems are now more robust, currencies typically floating (versus the fixed regimes of the past) and public sector debt levels have come down most of which is now denominated in local currency. Investors appear to accept that Chinese economic growth could be weaker for longer, as Beijing s historically direct interventionist policies appear to be markedly reduced this time round. The expectation of further loosening of Chinese policy is building, with a continuation of reserve requirement ratio (RRR) cuts anticipated. Officials are moving to ease the bottleneck in local government spending, allowing local government financing vehicles (LGFVs) to borrow from the state policy banks. 1 Source: Martin Currie and evestment Analytics, as at 30 September 2015.

5 active UPDATE: GLOBAL EQUITIES Meanwhile, the latest 50 basis point (bps) reduction in the RRR and 25 bps cut in interest rates appear to have delivered what the market was waiting for, along with supportive commitment to growth in the 13th five-year plan, announced at the end of the fifth Plenum. A long-term growth story Most importantly, investors shouldn t lose sight of the numerous long-term drivers underpinning emerging markets, which have been overshadowed by recent volatility. Demographic trends provide a young and growing workforce, and debt levels at both a sovereign and household level are low, especially compared with developed market peers. Many emerging market countries are also at an advantage in terms of natural resources and technology benefits. As long-term, fundamental and researchdriven stockpickers, we also see any shortterm volatility resulting from the rate hike as a buying opportunity. Our portfolio is made up of companies that are not overly leveraged and with no undue exposure to US dollar debt. The weeks ahead may therefore provide us the chance to add to our favoured companies at attractive valuations. active UPDATE is just one part of our range of investment materials. To access further perspectives on our strategies and key investment themes, visit our active library: Important information This information is issued and approved by Martin Currie Investment Management Limited ( MCIM ). It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested. The information contained has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The document may not be distributed to third parties and is intended only for the recipient. The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned. The opinions contained in this document are those of the named manager and analyst. They may not necessarily represent the views of other Martin Currie managers, analysts, strategies or funds. Any distribution of this material in Australia is by Martin Currie Australia Limited ( MCA ). Martin Currie Australia is a division of Legg Mason Asset Management Australia Limited (ABN ). Legg Mason Asset Management Australia Limited holds an Australian Financial Services Licence (AFSL No. AFSL ) issued pursuant to the Corporations Act Any distribution of this material in Singapore is by Martin Currie Asia Pte. Limited ( MCAP ) whose registered office is 3 Church Street, #15-03 Samsung Hub, Singapore Tel: (65) Fax: (65) This material has been approved by MCAP for distribution in Singapore to accredited and institutional investors. It must not be relied upon by retail investors. Martin Currie Investment Management Limited, registered in Scotland (no SC066107) Martin Currie Inc, incorporated in New York and having a UK branch registered in Scotland (no SF000300), Saltire Court, 20 Castle Terrace, Edinburgh EH1 2ES Tel: (44) Fax: (44) Both companies are authorised and regulated by the Financial Conduct Authority. Martin Currie Inc, 1350 Avenue of the Americas, Suite 3010, New York, NY is also registered with the Securities Exchange Commission. Please note that calls to the above numbers may be recorded.